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Financial Accounting Treatment of Non-Qualified Deferred Compensation Plans

May 22, 2018

Under generally accepted accounting principles (“GAAP”), the assets and liabilities associated with a Non-Qualified Deferred Compensation arrangement are accounted for and reported independently. This memorandum discusses the general accounting treatment for both in a situation where:
  • Employee amounts are deferred on a periodic basis; and
  • the company utilizes corporate owned life insurance (“COLI”) investments or mutual funds to informally finance the obligation.
Liability Accounting

Financial Accounting Standards Board Accounting Standards Codification (“FASB ASC”) Subtopic 710- 10, Compensation – General – Overall, provides that the deferred compensation obligation should be classified as a liability and adjusted to reflect the periodic changes in the fair market value of the amount owed to the employee.

The journal entries used to record the periodic transactional activity associated with the nonqualified deferred compensation obligation would be as follows:

Deferred Compensation Expense Debit           
Deferred Compensation Liability Credit
To reflect the crediting to participant accounts for deferral amounts (either salary deferrals or  company contributions, or both, if applicable)

Deferred Compensation Expense Debit
Deferred Compensation Liability Credit
To reflect the periodic gains in participant accounts (note this entry would be reversed in a  loss situation)

Upon distribution of a benefit payment to a participant, the journal entry would reflect the following:

Deferred Compensation Liability Debit
Cash (asset) Credit
To reflect the reduction in the liability due to the payment of the benefit to the participant

Note that liability accounting remains the same regardless of the informal financing method used
(COLI or mutual funds).

Asset Accounting

FASB ASC Section 710-10-25, Compensation – General – Overall – Recognition, provides that assets should be accounted for in accordance with generally accepted accounting principles for the particular investment.

COLI Investment
The accounting treatment for Corporate Owned Life Insurance (“COLI”) is governed by provisions of FASB ASC Subtopic 325-30, Investments – Other – Investments in Insurance Contracts. The methodology prescribed under the provisions of Subtopic 325-30 is considered a “cash surrender value” method and provides for the reporting of the cash surrender value as an asset for balance sheet purposes and the periodic change in the cash surrender value to be reported as a net amount for income statement purposes (i.e., the various components of the change in the COLI asset such as investment gains or losses, insurance charges, etc. are not required to be reported separately).

The journal entries used to record the periodic transactional activity associated with the COLIinvestment would be as follows:

Investment in COLI (asset) Debit
Cash (asset) Credit
To reflect the investment in COLI at the time of a premium payment

Investment in COLI (asset) Debit
Gain on Investment in COLI (income) Credit
To reflect the periodic change in the cash surrender value (note this entry would be reversed in the situation of a loss in the cash surrender value)

At such time the death of an insured occurs, the journal entry would reflect the following:

Cash (asset) Debit
Investment in COLI (asset) Credit
Gain on COLI proceeds (income) Credit
To reflect the receipt of COLI proceeds, to write off the associated cash surrender value, and to recognize gain for the excess amount

Mutual Fund Investment
The accounting treatment for investments in mutual funds is typically governed by the provisions of FASB ASC Subtopic 320-10, Investments – Debt and Equity Securities – Overall, wherein the predominant classification utilized in practice relative to a non-qualified deferred compensation arrangement is the “trading” category. Classificationas a “trading” investment under Subtopic 320-10 allows for unrealized holding gains and losses to be recognized in earnings in the current period.(a)

The journal entries used to record the periodic transactional activity associated with the mutual funds investment would be as follows:

Mutual Funds Investment (asset) Debit         
Cash (asset) Credit
To reflect the investment in mutual funds at the time of deposit

Mutual Fund Investment (asset) Debit
Dividends (income) Credit
Interest (income) Credit
Realized Gains (income) Credit
Unrealized Gains (income) Credit
To reflect the periodic activity in the mutual funds (note the realized and unrealized “gain” entries would be reversed if a loss situation occurred)

(a)Effective for fiscal years and interim periods within those fiscal years beginning after December 15, 2017, ASU 2016-01 (issued January 5, 2016) added ASC Topic 321, Investments-Equity Securities, and amends ASC Topic 825, Financial Instruments, to require entities to carry all investments in equity securities at fair value through net income.

Tax Accounting

FASB ASC Subtopic 740-10, Income Taxes – Overall, provides the guidance for the accounting for the income tax effects resulting from a company’s activities. Within Subtopic 740-10, a distinction is made where tax laws differ from the recognition and measurement requirements of financial reporting from a timing standpoint. These differences are termed “temporary” differences and give rise to the recording of deferred taxes. Other types of transactions generate differences between tax and financial reporting that are permanent in nature and,thus require no recognition of tax effect within the financial statements.

Several of the various transactions associated with the non-qualified deferred compensation plan described above have tax effect (either current or deferred and/ or both) as illustrated in the following journal entries.Note, however, that generally the tax provision (i.e., tax expense or benefit) is ultimately recognized at the company level (versus at a transactional level) such that the entries below would not be recorded on a stand-alone basis.

Earnings on Mutual Funds

Current Tax Expense Debit
Deferred Tax Expense Debit
Current Taxes Payable (liability) Credit
Deferred Tax Liability Credit
To reflect the current income tax expense (payable) relative to the periodic dividend, interest, and realized gains along with the deferred tax expense (liability) relative to the unrealized gains on the mutual fund investment – note the portion of the entry related to realized and unrealized gains would be reversed if a loss situation occurred.

Deferred Compensation Expense

Deferred Tax Asset Debit
Deferred Tax Benefit (income) Credit
To reflect the tax benefit (income) relative to the periodic growth in the liability resulting from participant deferrals, company contributions, and investment gains - note the portion of the entry related to the investment gains would be reversed if a loss situation occurred. Note that transactions related to the COLI investment would not be tax affected as COLI, under Subtopic 740-10, is most commonly treated as generating “non-temporary” or permanent differences.

Summary

This discussion provides an introduction to and a basic overview of the concepts and flow of transactions from the financial accounting perspective. It is for informational purposes only and not intended as legal, tax or accounting advice. Clients should consult with their own professional advisors as to how this material may apply to their own specific circumstances.                

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Newport Group, Inc. and its affiliates provide recordkeeping, plan administration, trust and custody, consulting, fiduciary consulting, insurance and brokerage services. Fiduciary consulting services are provided through Newport Group Securities, Inc., an SEC-registered investment adviser and FINRA-registered broker-dealer, and Newport Group Consulting, LLC, an SEC-registered investment adviser. Newport Group Securities, Inc. and Newport Group Consulting, LLC are affiliates of Newport Group, Inc. All securities transactions are provided through Newport Group Securities, Inc., in its role as broker-dealer. All fiduciary consulting services are provided through the registered investment advisers. When offering variable insurance products, Newport Group Securities, Inc. acts solely in its capacity as a broker-dealer. Trust and custody services provided by Newport Trust Company, a New Hampshire state chartered trust company and wholly owned subsidiary of Newport Group, Inc.